Monday, October 31, 2011

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months.

It turns out a "few months" might have been wildly optimistic. It was quickly evident that bond markets didn't show the same enthusiasm equity markets expressed for the supposed deal. That was huge red flag. The second red flag was the Bank of Spain announcing a stagnant 3Q GDP. From the Associated Press:

The Bank of Spain suggested that the flat growth calls into question the government's goal of reducing its deficit to 6 percent of GDP in 2011, from 9.2 percent last year...

...It said domestic demand fell because of lower government spending as a result of deficit-reducing austerity measures taken by regional governments and because of a moribund real estate market. Household and business spending posted small increases. Spain's economic woes stem largely from the collapse of a property bubble.

The Bank of Spain said there is still time to meet the deficit reduction target by the year's end but warned that fresh measures may be necessary.

Yes, you read that right...the Bank of Spain blamed missing deficit reduction targets on fiscal austerity and then suggests additional fiscal austerity as the solution. And as all nations in the Eurozone increasingly pursue fiscal austerity, we can only expect the nascent European recession to deepen. Eventually, the European public will have had enough of the downward spiral. How long will it be before Spain decides to aggressively push for a Greece solution of "voluntary" debt relief?

Finally, a lynchpin in the European debt deal - Greece - apparently isn't ready to abide by the terms of that deal. The public pressure is now too much. From the Financial Times:

Greece’s prime minister unexpectedly announced a referendum to approve a second EU bail-out deal for his austerity-hit country, less than a week after it was agreed with international creditors at a European Union summit...

...One senior EU official told the Financial Times that Mr Papandreou had appeared reticent about the components of the bail-out package during talks at last week’s summit of EU presidents and prime ministers but no one was prepared for the referendum announcement that came “like a bolt out of the blue...

...The vote would probably be held in January, when Greek bondholders were expected to sign up for a voluntary 50 per cent haircut being negotiated with the International Institute of Finance, wrapping up the new bail-out package. One Athens banker said: “This is a worrying decision by the prime minister. It could derail the whole process even before it’s properly started.”

Not only are the details of the grand European plan still in flux, but so are the broad brushstrokes! Clearly, the Greeks have just brought back into play all the uncertainty last week's summit was meant to dispel. It is not unreasonable to think the Greek electorate is more willing to technically default and start from scratch than their leaders. Indeed, shouldn't this be our baseline scenario?

Bottom Line: Last week's European Summit accomplished far less than even the reduced expectations going into last week. The cracks began appearing before the ink was dry. More worrisome is that the Greek leadership didn't even believe they were on board in the first place. Simply put, the world economy is no less fragile than it was a week ago. And in that fragility still lies the recession risk for a still struggling US economy.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. ...

Apparently, Keynesian economics works for policies that Republicans favor:

Bombs, Bridges and Jobs, by Paul Krugman, Commentary, NY Times: A few years back Representative Barney Frank coined an apt phrase for many of his colleagues: weaponized Keynesians, defined as those who believe “that the government does not create jobs when it funds the building of bridges or important research or retrains workers, but when it builds airplanes that are never going to be used in combat, that is of course economic salvation.”

Right now the weaponized Keynesians are out in full force... What’s bringing out the military big spenders is the approaching deadline for the so-called supercommittee to agree on a plan for deficit reduction. If no agreement is reached, this failure is supposed to trigger cuts in the defense budget.

Faced with this prospect, Republicans — who normally insist that the government can’t create jobs, and who have argued that lower, not higher, federal spending is the key to recovery — have rushed to oppose any cuts in military spending. Why? Because, they say, such cuts would destroy jobs. ...

First things first: Military spending does create jobs when the economy is depressed. ... Some liberals dislike this conclusion, but economics isn’t a morality play... But why would anyone prefer spending on destruction to spending on construction, prefer building weapons to building bridges? ...

But there are also darker motives behind weaponized Keynesianism.

For one thing, to admit that public spending on useful projects can create jobs is to admit that ... sometimes government is the solution, not the problem. ...

Beyond that, there’s a point made long ago by the Polish economist Michael Kalecki: to admit that the government can create jobs is to reduce the perceived importance of business confidence.

Appeals to confidence have always been a key debating point for opponents of taxes and regulation; Wall Street’s whining about President Obama is part of a long tradition in which wealthy businessmen and their flacks argue that any hint of populism on the part of politicians will upset people like them, and that this is bad for the economy. Once you concede that the government can act directly to create jobs, however, that whining loses much of its persuasive power — so Keynesian economics must be rejected, except in those cases where it’s being used to defend lucrative contracts.

So I welcome the sudden upsurge in weaponized Keynesianism... At a fundamental level, the opponents of any serious job-creation program know perfectly well that such a program would probably work... But they don’t want voters to know what they know, because that would hurt their larger agenda — keeping regulation and taxes on the wealthy at bay.

Sunday, October 30, 2011

The Promise and Problems of Pricing Carbon, by Robert Stavins: Friday, October 21st was a significant day for climate change policy worldwide and for the use of market-based approaches to environmental protection, but it went largely unnoticed across the country and around the world, outside, that is, of the State of California. On that day, the California Air Resources Board voted unanimously to adopt formally the nation’s most comprehensive cap-and-trade system, intended to provide financial incentives to firms to reduce the state’s greenhouse gas (GHG) emissions, notably carbon dioxide (CO2) emissions, to their 1990 level by the year 2020... Compliance will begin in 2013, eventually covering 85% of the state’s emissions.

...Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of a country, proposals for these policies inevitably bring forth significant opposition, particularly during difficult economic times.

In the United States, political polarization – which began some four decades ago, and accelerated during the economic downturn – has decimated what had long been the key political constituency in the Congress for environmental action, namely, the middle, including both moderate Republicans and moderate Democrats. Whereas Congressional debates about environmental and energy policy had long featured regional politics, they are now fully and simply partisan. In this political maelstrom, the failure of cap-and-trade climate policy in the U.S. Senate in 2010 was essentially collateral damage in a much larger political war.

It is possible that better economic times will reduce the pace – if not the direction – of political polarization. It is also possible that the ongoing challenge of large budgetary deficits in many countries will increase the political feasibility of new sources of revenue. When and if this happens, consumption taxes (as opposed to traditional taxes on income and investment) could receive heightened attention, and primary among these might be energy taxes, which can be significant climate policy instruments, depending upon their design.

That said, it is probably too soon to predict what the future will hold for the use of market-based policy instruments for climate change. Perhaps the two decades we have experienced of relatively high receptivity in the United States, Europe, and other parts of the world to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation. It is also possible, however, that the recent tarnishing of cap-and-trade in U.S. political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments. It is much too soon to say.

Yesterday, Ross Douthat argued that "higher taxes on America’s richest 1 percent" won't solve the problems with government. Thomas Friedman explains why that's wrong, and why a more equitable distribution of income is essential to stripping the ability of those at the top to control government:

Did You Hear the One About the Bankers?, by Thomas Friedman, Commentary, NY Times: Citigroup is lucky that Muammar el-Qaddafi was killed when he was. The Libyan leader’s death diverted attention from a lethal article involving Citigroup... The news was that Citigroup had to pay a $285 million fine to settle a case in which, with one hand, Citibank sold a package of toxic mortgage-backed securities to unsuspecting customers — securities that it knew were likely to go bust — and, with the other hand, shorted the same securities — that is, bet millions of dollars that they would go bust.

It doesn’t get any more immoral than this. ...

This gets to the core of why all the anti-Wall Street groups around the globe are resonating. I was in Tahrir Square in Cairo for the fall of Hosni Mubarak... When I talked to Egyptians, it was clear that what animated their protest, first and foremost, was ... a quest for “justice.” Many Egyptians were convinced that they lived in a deeply unjust society where the game had been rigged by the Mubarak family and its crony capitalists. Egypt shows what happens when a country adopts free-market capitalism without developing real rule of law and institutions.

But, then, what happened to us? Our financial industry has grown so large and rich it has corrupted our real institutions through political donations. As Senator Richard Durbin, an Illinois Democrat, bluntly said in a 2009 radio interview, despite having caused this crisis, these same financial firms “are still the most powerful lobby on Capitol Hill. And they, frankly, own the place.”

Our Congress today is a forum for legalized bribery. One consumer group using information from Opensecrets.org calculates that the financial services industry, including real estate, spent $2.3 billion on federal campaign contributions from 1990 to 2010, which was more than the health care, energy, defense, agriculture and transportation industries combined. Why are there 61 members on the House Committee on Financial Services? So many congressmen want to be in a position to sell votes to Wall Street. ...

U.S. congressmen should have to dress like Nascar drivers and wear the logos of all the banks, investment banks, insurance companies and real estate firms that they’re taking money from. The public needs to know.

Capitalism and free markets are the best engines for generating growth and relieving poverty — provided they are balanced with meaningful transparency, regulation and oversight. We lost that balance in the last decade. If we don’t get it back..., the cry for justice could turn ugly. ...

To what extent is fear of inflation, fear of deficits, and other fears holding up more government help for struggling, unemployed households the result of the powerful interests who control Congress standing in the way? My answer, as ought to be clear from recent columns (here, here, and here), is that the imbalance in political power that comes with such a large degree of inequality is a large factor in the government's tepid response to the unemployment crisis.

Pass legislation to give more oversight, accountability, and judicial review of the NLRB's decisions.

Pass the Employee Rights Act (S. 1507) to protect the rights of workers.

Repeal the prevailing-wage requirements in the Davis-Bacon Act.

The 10 point plan is to strip wage negotiation power from workers, cut benefits to working class households ("fiscal sanity"), repeal health care reform, repeal Dodd-Frank, repeal regulations on energy companies so they can drill pretty much anywhere, and cut taxes on businesses and the wealthy (never mind that this "fiscal insanity" will make the deficit worse and require bigger cuts to benefits). In other words, it's a mainstream Republican plan.

Somehow, it is claimed, after workers have lost power in wage negotiations, lost social insurance and other protections, live in more polluted environments, have fewer health care options, and are more likely to be asked to bail out deregulated banks yet again while getting no help themselves, they will be better off.

the mental-health effects of TV viewing might run even deeper than addiction, consumerism, loss of social trust, and political propaganda. Perhaps TV is rewiring heavy viewers’ brains and impairing their cognitive capacities

KM: The fact is, guys have not done well over the last few years as asset prices generally have gone down. I don’t doubt that. But to say that you lost money in the worst asset crash in memory — and franchises haven’t gone down nearly as much as many assets have gone down — that’s not telling you you need concessions going forward.

If you go back before the last 3-5 years, these guys did incredibly well. Their franchises weren’t going up by 4 or 5 percent, they were going up by 8 or 9 percent a year. They were making money hand over fist. Should [the players] get credit for that? Should we get that money back? Now those are different people in some cases. They need to go get their money from the guys they bought the franchises from. That’s the guy who has all your money. Not us.

But who bought anything in ’07 that they’re happy with the price they paid? If you bought a house in ’07, if you bought stocks in ’07, if you bought bonds in ’07 — I don’t care what you bought, you’re not happy with the price you paid. When you buy at the top, you don’t make your money. That’s not unique to the NBA, that’s everywhere in life. But by and large, NBA franchise ownership has been a good investment. You can’t base long-run projections on how you did in the biggest financial downturn of the last 50 years. On that basis, there are no good investments out there. But we know that’s not true.

The Path Not Taken, by Paul Krugman, Commentary NY Times: Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed,... the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine... The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So ... a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed. ...

The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.

Some economists weren’t convinced. ... But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank...

Now, however, the results are in, and the picture isn’t pretty. Greece has been pushed by its austerity measures into an ever-deepening slump... Britain’s economy has stalled under the impact of austerity...

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? ...

Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

So how’s it going? Iceland hasn’t avoided major economic damage... But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable... “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

Thursday, October 27, 2011

Perry campaign: The purpose of this bold tax proposal is to give the economy the jumpstart it needs to get people back to work. ... Gov. Perry is confident that the economic growth that results from this plan will generate the necessary revenue to balance the budget by 2020.

I used the phrase "charlatans and cranks" in the first edition of my principles textbook to describe some of the economic advisers to Ronald Reagan, who told him that broad-based income tax cuts would have such large supply-side effects that the tax cuts would raise tax revenue. I did not find such a claim credible, based on the available evidence. I never have, and I still don't.

There's no mystery here. The tax cuts for the wealthy will be paid for by cutting benefits for the working class, the poor, and others who are already having a tough time making ends meet.

... Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek’s position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don’t know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

Wouter den Haan argues that measures of the financial sector’s contribution to economic activity in the national income accounts overstate "its true value to a modern economy. As such, regulation that makes it more difficult for the sector to perform some activities is not necessarily a bad thing." This supports the arguments I've been making about the "mal-distribution of income" in recent years, so no disagreement here:

Why do we need a financial sector?, by Wouter den Haan, Vox EU: According to national-income account data, financial institutions are responsible for an important fraction of what countries produce each year. A standard way to measure a sector’s contribution to GDP is to calculate its value added, that is, the difference between the value of the products produced minus the value of the products used in production.

This “value added” is distributed as income or reinvested in the financial sector.

Figure 1 displays the fraction of US GDP produced by the financial and insurance sector. During the post-war period this fraction increased from 2% to 8%.

The UK’s financial sector generated 9% of total British value added in the last quarter of 2008; this was only 5% in 1970.1

Figure1. Value added of the finance and insurance sectors in the US (% of GDP)

Source: Bureau of Economic Analysis

An increase in inputs (capital and labour) is only part of the story. Value added per worker has also increased substantially. Weale (2009) reports that earnings per employee in the UK financial sector were 2.1 times average earnings in 2007. In Philippon and Reshef (2008), it is shown that the rise in the relative financial wage is related to financial deregulation.

The elevated position of the financial sector is even more obvious when we take a look at corporate profits.

In the first couple of decades following the Second World War, profits in the financial sector were around 1.5% of total profits;

Recently, this number was as high as 15%.

Pay versus output

Without doubt, these numbers indicate that the stakeholders in the financial sector (employees and investors) receive a substantial chunk of GDP. But the numbers do not necessarily imply that the sector produces this much. Nor do they imply that the actual value of what the sector produces has gone up a lot during the post-war period.

To understand why there could be a difference between the income received and the value of what is being produced, consider the basis of this deduction. In a competitive economy, the price of a good equals its marginal cost, and consumers buy it up to the point where their marginal benefit equals the price. If it is an intermediate good, the price equals the value of the good’s marginal productivity to the purchasers. Thus, the value of output works well as a measure of both the cost and the benefit to society. That’s the magic of the market.

However, if the sector is imperfectly competitive, the price will exceed the social marginal cost and we’ll see value added being artificially transferred between sectors. As the financial sector is very concentrated, this is one reason we should expect the payments to factors in banking to exceed the value created – taking, as a base case, the prices that would be observed if the sector were competitive.

A second wedge between wage and value arises from the implicit insurance that the financial sector gets. As financial service providers do not pay for the “moral hazard” they create, the true value of financial services is systematically less than the payment to factors. Curry and Shibut (2000) calculate that the fiscal cost, net of recoveries, of the 1980s US Savings and Loan Crisis was $124 billion, or roughly 3% of GDP. This cost ignores other costs such as output losses, and this was a relatively mild crisis. Laeven and Valencia (2008) consider 42 crisis episodes and find an average net fiscal cost of 13.3%.2 It would not be fair to attribute these losses solely to the financial sector, but the magnitudes of the numbers suggest that this wedge could quantitatively be very important.

A third wedge comes from negative spillovers. The financial sector may provide services that are useful to a client, but not to society as a whole. For example, a financial institution may help to structure a firm’s financing in such a way that the firm pays less taxes. Such a transaction would not increase production, unless lower taxes help the firm to produce more. Nevertheless, such transactions will count as value added generated by the financial sector. A rather stark analogy could be drawn with the cigarette industry, where it is quite clear that the payments to factors do not really measure social value added since the cost of smoking-induced health problems falls on the taxpayer (in most nations).

Although the sector’s contribution is not easy to measure, there are some things we do know.

First, the financial sector provides useful services. That is, the sector’s value added should be positive.

Second, financial-sector value added reported in the national income accounts was probably overvalued in the years leading up to Great Recession.

The financial sector extracted huge fees from the rest of the economy to construct opaque securities that were so complex that only a few understood how risky they were.3 If fees (prices) had accurately reflected the true value of the products, then some of these fees should have been negative, since many such products were not beneficial to the buyer or to society as a whole.

Several important questions need answers.

What are the reasons for the observed substantial increase in the share of GDP received by the financial sector?

What are the services that the financial sector in today’s world does (or should) provide that increase the production of things we care about?

What is the value of these services? This is a tough question for the type of products delivered by the financial sector, because the nature of the services changes over time. For products like computers, we can measure characteristics such as speed and memory and measure how much computing power you get. If a bank becomes better at preventing default, then it provides more “financial services” for each unit of loans issued. But how can we correct for such changes in risk exposure? One possibility to measure the effectiveness of the services provided is to investigate how differences in financial sectors across countries are related to valuable characteristics such as smaller business cycles, better life-time consumption patterns, and innovative firms not facing financing constraints.4

What is the value of modern finance versus traditional finance?

Although the financial sector has been in the limelight since the outbreak of the crisis, these questions have received little attention. There is a substantial academic literature investigating the positive (and negative) effects of the presence of developed financial markets on long-term growth.5 But there is not that much research done on the question of which aspects of the current financial system are important for today’s economies.

One would think that it is essential to fully understand what contributions the financial sector, and especially banks, can offer before engaging in a discussion on how to regulate this sector. If the key aspects of the financial sector that foster growth are relatively simple, then we would not have to worry that, say, increased capital requirements would have negative impacts on the economy. Then it would make more sense to worry about there being enough competition, so that we do not pay a lot for relatively simple activities. But if sustained economic growth requires a creative financial sector capable of performing complex tasks, then we should worry that regulation is not going to debilitate this sector.

It is surprising that these questions currently get so little attention. In an abstract sense, we know what roles financial institutions fulfil. In particular, (i) financial institutions avoid duplication both when monitoring loans and collecting information, (ii) they help to smooth consumption, and (iii) they provide liquidity.6 There are many enjoyable descriptions of some activities enacted in the financial sector that seem hard to reconcile with the laudable tasks thought of by economists. Moreover, knowing what the tasks of the financial sector are in theory does not tell us whether those tasks are fulfilled efficiently and at the right price. Nor does it tell us why the income earned by the financial sector has increased so much. As pointed out by Philippon (2008), in the 1960s outstanding economic growth was achieved with a small financial sector. Has it become more difficult to obtain information so that we now need to allocate more resources to the financial sector?

Some articles in the literature address the questions posed here. Chari and Kehoe (2009) use US firm-level data and find that the amount spent on investment exceeds the amount of internally-available funds (revenues minus wages minus material costs minus interest payments minus taxes) for only 16% of all firms considered. If investment could in principal be done using the firms’ own funds, then the role for financial intermediaries is obviously diminished. Haldane (2010) discusses in detail the earnings of the financial sector and concludes that “risk illusion, rather than a productivity miracle, appears to have driven high returns to finance”. Philippon and Reshef (2008) study wages earned in the financial sector and conclude that a large part of the observed wage differential between the financial sector and the rest of the economy cannot be explained by observables like skill differences, but is likely to be due to the presence of rents. Philippon (2008) argues that an increase in the types of firms that invest (young firms) can explain part of the increased income share of the financial sector; the increase in the last decade remains puzzling.

A similar view is expressed by Popov and Smets (2011), who argue that deeper financial markets in the US relative to those of the European continent are, to a large extent, responsible for the larger increases in productivity and faster pace of industrial innovation. One piece of evidence supporting this view is the empirical study of Popov and Roosenboom (2009), who find that better access to private equity and venture capital have a positive impact on the number of patents. Den Haan and Sterk (2011) reconsider the popular hypothesis that innovations in financial markets should make it easier for financial institutions to smooth business cycles. The idea of this hypothesis is that better access to bank finance ensures that consumers and firms do not have to make decisions that are bad for the economy as a whole, such as firing workers or postponing purchases which in turn could trigger additional layoffs. Den Haan and Sterk (2011) analyse in detail the behaviour of consumer loans and real activity, and find that there is no evidence that supports the hypothesis that financial innovations dampened business cycles, even when the recent crisis is excluded. Lozej (2011) addresses the same question using firm loans. Although the evidence presented by Lozej (2011) is a bit more mixed, there is at best weak evidence that the changes in the financial sector contributed to smaller business cycles during the period before the recent crisis.

Conclusion

The literature indicates that some tasks of the financial sector are beneficial, some attributes of financial institutions matter, and others matter less so or not at all. The recent publication of the Vickers report is a good occasion to investigate what activities of the financial sector are beneficial for today’s way of life, and whether they are affected by proposed regulation. Without doubt, various proposed changes in regulation will be costly for the financial sector and make it more difficult for the sector to perform some activities. But that is not necessarily a bad thing. If a change would cost the financial sector, say, one billion a year but does not affect the total amount being produced, then it just means that there is an extra billion for the other sectors.

1 Unless stated otherwise, the numbers in this paragraph are from Haldane (2010). 2 The highest net fiscal cost was equal to 55.1% and attained during the 1980 Argentinian crisis. In contrast, the net fiscal cost of the banking crisis in Sweden during the early 1990s was close to zero. 3 There are many other examples. I recently transferred €10,000 from a Dutch Euro account to a Euro account held by a British bank. The transfer cost me €455. That is, a personal loss of 4.6% in one day. Given that the costs are virtually zero, the fees would be almost fully counted as value added in the national income accounts. 4 An example is Popov and Roosenboom (2009). 5 Levine (2005) provides an excellent survey and concludes that a well-developed financial sector is beneficial for growth. Demirguc-Kunt, Beck, Honohan (2008) argue that in some cases the effect could be the opposite. 6 See Gorton and Winton (2003). 7 See, for example, Lewis (1989), Lowenstein (2000), and Partnoy (1997).

Wednesday, October 26, 2011

Waiting, Waiting, Waiting, by Tim Duy: US markets are closed, with everyone left waiting for the news from Europe and the 3Q11 US GDP report. Expectations appear to be high for both, but I am considerably more certain the latter will deliver on those expectations. Europe is certainly more interesting. Over the last few weeks, market participants looked to have grasped at every little straw that offered hope on the European story, and it remains to be seen whether or not that will continue when rumours turn to news.

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months. Some specific concerns:

The goalposts are already moving. The Eurozone economy is headed into recession - the combination of fiscal austerity and financial turmoil have already set in motion the inevitable contraction of demand that will soon threaten deficit reduction goals across the continent. And it is only a matter of time before the ratings agencies recognize this as well. The European solution, of course, will be additional fiscal austerity. It didn't work in Greece, and it won't work for the Eurozone as a whole.

The lack of sufficient ECB participation. The German contingent has effectively shut down the ECB. From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery. But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

When in doubt, turn to financial engineering. The faith in financial engineering never ceases to amaze me. Efforts to leverage up the EFSF are almost comical, and they reveal another problem in this exercise - no one (in particular, Germany) is willing to bring sufficient resources to the table. Wolfgang Munchau:

Leverage can have different economic functions, but in these cases it simply disguises a lack of money.

The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality.

Turning to developing nations for help. If it wasn't so sad, it would almost be funny. Reports of BRIC participation as EFSF investors have been circulated for weeks. The latest version that reportedly sparked today's market rally:

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.

My goodness, have the Europeans learned nothing from the Americans? Sure, we let the fox into the hen house and didn't have the common sense to chase him out a decade ago. The Europeans are now opening the doors and inviting in the fox. Michael Pettis had a long, must read piece on this topic earlier this month:

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

The idea on the table is for the BRICs to buy into the EFSF, not struggling debt directly. Even so, they need Euros to buy EFSF debt, which will represent a capital inflow into Europe. The periphery nations are struggling to rebalance internally. The strong Euro is not helping matters. Ultimately, additional capital inflows from the BRICs will only add additional strength to the Euro, encouraging further contractionary external adjustment that only complicates the internal adjustment challenges. The Europeans really should be seeking a European solution, not adding more external stakeholders to the fray.

I guess we should all get some good sleep tonight, as tomorrow will be a busy day.

Wither CDS?, by Tim Duy: Something I have been wondering about in the context of the supposed "voluntary" writedowns being forced upon holders of Greek debt - what exactly is the point of the credit default swap market for sovereign debt if politicians will act to ensure that any default never triggers a credit event? The FT provides an answer:

Now, politicians are seeking to take their revenge: not just with the recent introduction of bans on some trading of credit default swaps but also in their attempts to ensure that any haircut on Greek government bonds does not trigger a credit event.

Combined, these two events could spell the end of the credit default swaps market, say bankers.

The end of the credit default swap market might not be without consequences:

But these aims could backfire. Some bankers believe, rather than lowering borrowing costs, these moves will have the reverse effect and also restrict lending to their banks and companies.

In the wake of the CDS ban, some banks are already pushing alternative strategies that risk driving up government bond yields even further. Last week Citigroup, the leading US bank, recommended selling the bonds of France, Italy and Spain because of the trading ban while other banks have warned they could unload peripheral bonds if CDS payouts are ruled out on Greece.

Not exactly a good time for higher rates in the periphery. Will the loss of the CDS market ultimately improve or undermine financial market functioning? This is outside my area of expertise, leaving me particularly curious on how events unfold.

Where Is the New Keynes?, by John Cassidy: On Monday, I was on Leonard Lopate’s WNYC radio show talking about my recent article on John Maynard Keynes. (The piece is no longer behind a firewall. You can read it here, and listen to the interview here.) At the end of the show, Leonard asked me an interesting question: Has the financial crisis and Great Recession produced any big new economic ideas? ...

Certainly, there is no new Keynes. But I do think that some important ideas have been discovered—or, rather, rediscovered. Here are six of them...:

1. Finance matters. This lesson might seem obvious to the man in the street, but many economists somehow managed to forget it. ...

2. Credit busts are different from ordinary recessions. ...

3. Positive feedback and multiple equilibria have to be taken seriously. With the rise of rational expectations theory, the idea that financial markets and entire economies can spiral into bad outcomes—and for no very good reason—was relegated to a mathematical curiosity: so called “sunspots.” Now, the notion is back, and for good reason. It appears to describe the world pretty well. ...

5. Monetary policy doesn’t always work very well. This lesson should have been relearned in Japan. One person who did relearn it was Paul Krugman. ...

6. Fiscal stimulus programs don’t provide a panacea for deep recessions, but the alternatives—do-nothing policies or austerity—are much worse. If you doubt this, I would suggest you look at what is happening in Greece and the United Kingdom, where austerity programs have been in effect for more than a year. As for the Obama stimulus, most serious studies show it did have a positive impact on G.D.P. growth and job creation—as detailed in this helpful post by Dylan Matthews...

Looking at this list, anyone familiar with Keynes will quickly realize that almost all of the points on it can be found in his writings, at least in embryo form. ...

I'll add one more: Before the crisis Alan Greenspan assured us that there wasn't a housing bubble, and even if there was, and it popped, the Fed could contain its effects and clean up afterward. Nothing to worry about. That was wrong.

That points to one more: The Fed needs better ways to identify bubbles. Because of the belief that bubbles could be contained and easily mopped up, little effort was made to find ways to identify bubbles as they were inflating. Now that we know how much damage bubbles can do -- something we should have known already -- we need to put effort into finding reliable indications of bubbles, and then take action to stop them from doing severe damage.

Another: In this type of recession, saving banks is not enough to restore the economy. It's critical to help households too.

Trends in the Distribution of Income, by Edward Harris and Frank Sammartino, CBO Director's Blog: From 1979 to 2007, real (inflation-adjusted) average household income, measured after government transfers and federal taxes, grew by 62 percent. That growth was not equal across the income distribution: Income after government transfers and federal taxes (denoted as after-tax income) for households at the higher end of the income scale rose much more rapidly than income for households in the middle and at the lower end of the income scale.

In a study prepared at the request of the Chairman and former Ranking Member of the Senate Committee on Finance, CBO examines the trends in the distribution of household income between 1979 and 2007. (Those endpoints allow comparisons between periods of similar overall economic activity.)

After-Tax Income Grew More for the Highest-Income Households

CBO finds that between 1979 and 2007:

For the 1 percent of the population with the highest income, average real after-tax household income grew by 275 percent (see figure below).

For others in the 20 percent of the population with the highest income, average real after-tax household income grew by 65 percent.

For the 60 percent of the population in the middle of the income scale, the growth in average real after-tax household income was just under 40 percent.

For the 20 percent of the population with the lowest income, the growth in average real after-tax household income was about 18 percent.

Growth in Real After-Tax Income from 1979 to 2007

As a result of that uneven income growth, the distribution of after-tax household income in the United States was substantially more unequal in 2007 than in 1979: The share of income accruing to higher-income households increased, whereas the share accruing to other households declined. Specifically:

The share of after-tax household income going to the highest income quintile grew from 43 percent in 1979 to 53 percent in 2007. (Each quintile contains one-fifth of the population, ranked by adjusted household income.)

The share of after-tax household income for the 1 percent of the population with the highest income more than doubled, climbing from nearly 8 percent in 1979 to 17 percent in 2007.

The population in the lowest income quintile received about 7 percent of after-tax household income in 1979; by 2007, their share of after-tax income fell to about 5 percent. The middle three income quintiles all saw their shares of after-tax income decline by 2 to 3 percentage points between 1979 and 2007.

Market Income Shifted Toward Higher-Income Households

The major reason for the growing unevenness in the distribution of after-tax income was an increase in the concentration of market income—income measured before government transfers and taxes—in favor of higher-income households. Specifically, over the 1979 to 2007 period, the highest income quintile’s share of market income increased from 50 percent to 60 percent (see figure below), while the share of market income for every other quintile declined. In fact, the distribution of market income became more unequal almost continuously between 1979 and 2007 except during the recessions in 1990–1991 and 2001.

Shares of Market Income, 1979 and 2007

Two factors accounted for the changing distribution of market income. One was an increase in the concentration of each source of market income, which consists of labor income (such as cash wages and salaries and employer-paid health insurance premiums), business income, capital gains, capital income, and other income. All of those sources of market income were less evenly distributed in 2007 than they were in 1979.

The other factor was a shift in the composition of market income. Labor income has been more evenly distributed than capital and business income, and both capital income and business income have been more evenly distributed than capital gains. Between 1979 and 2007, the share of income coming from capital gains and business income increased, while the share coming from labor income and capital income decreased.

Market Income Grew Rapidly for the Highest-Income Households

The rapid growth in average real household market income for the 1 percent of the population with the highest income was a major factor contributing to the growing dispersion of income. Average real household market income for the highest income group tripled over the period, whereas such income increased by about 19 percent for a household at the midpoint of the income distribution. As a result, the share of total market income received by the top 1 percent of the population more than doubled between 1979 and 2007, growing from about 10 percent to more than 20 percent.

The precise reasons for the rapid growth in income at the top are not well understood, though researchers have offered several potential rationales, including technical innovations that have changed the labor market for superstars (such as actors, athletes, and musicians), changes in the governance and structure of executive compensation, increases in firms’ size and complexity, and the increasing scale of financial-sector activities.

The composition of income for the 1 percent of the population with the highest income changed significantly from 1979 to 2007, as the shares from labor and business income increased and the shares of income represented by capital income decreased as a share of their income.

Government Transfers and Federal Taxes Became Less Redistributive

Although an increasing concentration of market income was the primary force behind growing inequality in the distribution of after-tax household income, shifts in government transfers (cash payments to individuals and estimates of the value of in-kind benefits) and federal taxes also contributed to that increase in inequality. CBO estimates that the dispersion of market income grew by about one-quarter between 1979 and 2007, while the dispersion of income after government transfer and federal taxes grew by about one-third.

Because government transfers and federal taxes are both progressive, the distribution of after-transfer, after-federal-tax household income is more equal than is the distribution of market income. Nevertheless, the equalizing effect of transfers and federal taxes on household income was smaller in 2007 than it had been in 1979.

Specifically, in 1979, households in the bottom quintile received more than 50 percent of transfer payments. In 2007, similar households received about 35 percent of transfers. That shift reflects the growth in spending for programs focused on the elderly population (such as Social Security and unemployment compensation), in which benefits are not limited to low-income households.

Likewise, the equalizing effect of federal taxes was smaller. Over the 1979–2007 period, the overall average federal tax rate fell by a small amount, the composition of federal revenues shifted away from progressive income taxes to less-progressive payroll taxes, and income taxes became slightly more concentrated at the higher end of the income scale. The effect of the first two factors outweighed the effect of the third, reducing the extent to which taxes lessened the dispersion of household income.

Economists from across the political spectrum have also weighed into this debate and reached the same conclusion. ... Nonetheless, two commonly repeated misconceptions are that uncertainty created by proposed regulations is holding back business investment and hiring and that the overall burden of existing regulations is so high that firms have reduced their hiring.

If regulatory uncertainty was a major impediment to hiring right now, we would expect to see indications of this in one or more of the following: business profits; trends in the workforce, capacity utilization, and business investment; differences between industries undergoing significant regulatory changes and those that are not; differences between the United States and other countries that are not undergoing the same changes; or surveys of business owners and economists. As discussed in a detailed review of the evidence below, none of these data support the claim that regulatory uncertainty is holding back hiring. ...

Indeed, nominal rates were the lowest in almost four decades and below Taylor rates in many countries, while real rates were negative (Taylor 2007, Rajan 2010, Reinhart and Rogoff 2010, among others). Expansionary monetary policy and credit risk-taking followed by restrictive monetary policy possibly led to the financial crisis during the 1990s in Japan (Allen and Gale 2004), while lower real interest rates preceded banking crises in 47 countries (von Hagen and Ho 2007). This time the regulatory arbitrage for bank capital associated with the high degree of bank leverage, the widespread use of complex and opaque financial instruments including loan securitization, and the increased interconnectedness among financial intermediaries may have intensified the resultant risk-taking associated with expansive monetary policy (Calomiris 2009, Mian and Sufi 2009, Acharya and Richardson 2010).

During the crisis, commentators also continuously raised concerns that a zero policy interest rate combined with additional and far-reaching quantitative easing, while alleviating the immediate predicament of many financial market participants, were sowing the seeds for the next credit bubble (Giavazzi and Giovannini 2010).

Recent theoretical work has modeled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive.

Indeed, lower short-term interest rates may reduce the threat of deposit withdrawals, and improve banks’ liquidity and net worth, allowing banks to relax their lending standards and to increase their credit and liquidity risk-taking. Acute agency problems in banks, when their capital is low for example, combined with a reliance on short-term funding, may therefore lead short-term interest rates – more than long-term rates – to spur risk-taking. Finally, low short-term interest rates make riskless assets less attractive and may lead to a search-for-yield by those financial institutions that have short time horizons.1

Concurrent with these theoretical developments, recent empirical work has begun to study the impact of monetary policy on credit risk-taking by banks. Recent papers that in essence study the impact of short-term interest rates on the risk composition of the supply of credit follow a longstanding and wide literature that has analyzed its impact on the aggregate volume of credit in the economy, and on the changes in the composition of credit in response to changes in the quality of the pool of borrowers.2

In Jiménez et al (2011), our co-authors and we use a uniquely comprehensive credit register from Spain that, matched with bank and firm relevant information, contains exhaustive loan (bank-firm) level data on all outstanding business loan contracts at a quarterly frequency since 1984:IV, and loan application information at the bank-firm level at a monthly frequency since 2002:02.

Our identification strategy consists out of three crucial components:

(1) Interacting the overnight interest rate with bank capital (the main theory-based measure of bank agency problems) and a firm credit-risk measure

(2) Accounting fully for both observed and unobserved time-varying bank and firm heterogeneity by saturating the specifications with time*bank and time*firm fixed effects (at a quarterly or monthly frequency), and when possible, also controlling for unobserved heterogeneity in bank-firm matching with bank*firm fixed effects and time-varying bank-firm characteristics (past bank-firm credit volume for example).

(3) Including in all key specifications – and concurrent with the short-term rate – also the ten-year government-bond interest rate, in particular in a triple interaction with bank capital and a firm credit risk measure (as in (2)).

Spain offers an ideal setting to employ this identification strategy because it has an exhaustive credit register from the banking supervisor, an economic system dominated by banks and, for the last 22 years, a fairly exogenous monetary policy.

We find the following results for a decrease in the overnight interest rate (even when controlling for changes in the ten-year government-bond interest rate):

(1) On the intensive margin, a rate cut induces lowly capitalized banks to expand credit to riskier firms more than highly capitalized banks, where firm credit risk is either measured as having an ex ante bad credit history (ie, past doubtful loans) or as facing future credit defaults.

(2) On the extensive margin of ended lending, a rate cut has if anything a similar impact, ie, lowly capitalized banks end credit to riskier firms less often than highly capitalized banks.

(3) On the extensive margin of new lending, a rate cut leads lower-capitalized banks to more likely grant loans to applicants with a worse credit history, and to grant them larger loans or loans with a longer maturity. A decrease in the long-term rate has a much smaller or no such effects on bank risk-taking (on all margins of lending).

Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate.

In work with Vasso Ioannidou, we also investigate the impact of monetary policy on the risk-taking by banks (Ioannidou et al 2009). This study focuses on the pricing of the risk banks take in Bolivia (relying on a different and complementary identification strategy to Jiménez, et al 2011 and studying data from a developing country). Examining the credit register from Bolivia from 1999 to 2003, we find that, when the US federal-funds rate decreases, bank credit risk increases while loan spreads drop (the Bolivian economy is largely dollarized and most loans are dollar-denominated making the federal-funds rate the appropriate but exogenously determined monetary-policy rate). The latter result is again suggestive of excessive bank risk-taking following decreases in the monetary-policy rate. Hence, despite using very different methodologies, and credit registers covering different countries, time periods, and monetary policy regimes, both papers find strikingly consistent results.3

There are a number of natural extensions to these studies. Our focus on the impact of monetary policy on individual loan granting overlooks the correlations between borrower risk and the impact on each individual bank’s portfolio or the correlations between all the banks’ portfolios and the resulting systemic-risk impact of monetary policy. In addition, both studies focus on the effects of monetary policy on the composition of credit supply in only one dimension, ie, firm risk. Industry affiliation or portfolio distribution between mortgages, consumer loans and business loans for example may also change. Given the intensity of agency problems, social costs and externalities in banking, banks’ risk-taking – and other compositional changes of their credit supply for that matter – can be expected to directly impact future financial stability and economic growth. We plan to broach all such extensions in future work.

Disclaimer: Any views expressed are only those of the authors and should not be attributed to the Banco de España, the European Central Bank, or the Eurosystem.

The U.S., seeking to attract investors who might otherwise avoid Treasuries amid a $1.3 trillion budget deficit, is considering the sale of floating- rate notes in what would be its first new security since it began offering inflation-linked debt 14 years ago.

The Treasury Department said this month it asked Wall Street’s biggest bond dealers for recommendations on structuring securities with coupons that rise or fall with benchmark rates. Officials are scheduled to gather with the 22 primary dealers, who include Goldman Sachs Group Inc. and JPMorgan Chase & Co., on Oct. 28 as it decides whether to go further during their regular meeting that precedes each quarterly refunding.

I find this idea intriguing. On the surface, with US 10-year debt hovering around 2 percent, there seems to be plenty of demand to dry up whatever Treasury issues. And it looks like a wise move to lock in as much debt as possible at those low rates. That said, at some point in the future (hopefully) rates will rise, and it is easy to see an inflection point where investors, wary that monetary policy may shift abruptly, would be wary to add to their Treasury holdings. Having a floating rate product on hand could be important in such circumstances, preventing any abrupt funding shortfalls and rates spikes by offering investors a form of insurance against rising rates.

Daniel Indiviglio at the Atlantic offers up some potential problems with such a product. First, he correctly notes the desire to lock in today's low rates. Second:

Tying U.S. debt costs to how interest rates rise and fall could also be dangerous. For every $1 billion in floating-rate debt that the Treasury issues, a 0.5% (50 basis point) increase in interest rates would result in its debt costs rising by $5 million. You can imagine how quickly U.S. debt costs could rise if the government had something like $1 trillion in floating rate debt and interest rates jumped a few percent in a year. Suddenly, the government would have to issue tens of billions of dollars in additional debt just to keep up with rising interest rates.

As I noted, I think this product would be particularly useful in the expected transition to higher rates and would not expect it to be a primary funding mechanism. I can also see a benefit in a mechanism that explicitly penalizes the fiscal authority for overspending should actual fiscal constraints emerge in the future. Consider it something of an automatic stabilizer - more spending power automatically emerges when the economy dips and debt costs fall, and vice-versa. Indiviglio offers another potential problem:

And if you think that the government puts too much pressure on the Federal Reserve to act now, just wait until it directly controls a portion of the nation's interest costs. Floating-rate note would likely include a benchmark rate controlled by the Fed. So if the U.S. is ever struggling to meet its debt obligations, the Fed may feel obligated to keep interest rates lower than it otherwise would. If it increases rates, a payment shock could affect U.S. financial stability. Due to this, floating-rate debt could lead to higher inflation, since the Fed may feel pressured to leave interest rates lower for longer.

I thought the Federal Reserve would be a natural buyer of such debt. Consider the current (what I think overplayed) worry that the Federal Reserve is threatened by huge captial losses on its existing portfolio when interest rates rise. There is some concern that the Fed will resist raising rates to avoid the erosion of it capital base, as it would lose some of its independence if monetary policymakers needed a capital injection from the US Treasury. In addition, there is a related concern that should the Fed need to raise interest on reserves abruptly to control inflation, then the Fed's expenses will surge well above the interest paid on its Treasury portfolio. Yet again another trip for a Treasury bailout.

While I was not concerned much about these scenarios, note that they would both be eliminated if the Fed held a significant portion of floating rate debt in its portfolio. It would automatically create a revenue stream to support higher interest on reserves. Obviously, the risk of capital loss would recede. Moreover, a large Federal Reserve holding of such debt would protect the taxpayer as well - higher debt servicing cost would just flow right back to the US Treasury (after Federal Reserve expenses). Finally, note then-Federal Reserve Governor Ben Bernanke made a similar proposal in his famous 2003 Japanese monetary policy speech. Essentially, a floating rate portfolio eliminates some imagined or real constraints on monetary policy, reducing the risk that additional quantitative easing will turn inflationary.

In short, I think the US Treasury has good reason to consider adding floating rate debt - and should find a ready buyer not only in Wall Street, but just across town.

Monday, October 24, 2011

New research from Jesse Rothstein shows that, contrary to what you may have heard from those who are trying to blame our economic problems on government programs rather than malfeasance on Wall Street, unemployment insurance is not the cause of the slow recovery of employment:

Unemployment Insurance and Job Search in the Great Recession, by Jesse Rothstein, NBER Working Paper No. 17534 [open link]: Nearly two years after the official end of the "Great Recession," the labor market remains historically weak. One candidate explanation is supply-side effects driven by dramatic expansions of Unemployment Insurance (UI) benefit durations, to as many as 99 weeks. This paper investigates the effect of these UI extensions on job search and reemployment. I use the longitudinal structure of the Current Population Survey to construct unemployment exit hazards that vary across states, over time, and between individuals with differing unemployment durations. I then use these hazards to explore a variety of comparisons intended to distinguish the effects of UI extensions from other determinants of employment outcomes.

The various specifications yield quite similar results. UI extensions had significant but small negative effects on the probability that the eligible unemployed would exit unemployment, concentrated among the long-term unemployed. The estimates imply that UI benefit extensions raised the unemployment rate in early 2011 by only about 0.1-0.5 percentage points, much less than is implied by previous analyses, with at least half of this effect attributable to reduced labor force exit among the unemployed rather than to the changes in reemployment rates that are of greater policy concern.

I’ll get to the tragedy in a minute. First, let’s talk about the pratfalls... Greece, where the crisis began, is no more than a grim sideshow. The clear and present danger comes instead from ... Italy, the euro area’s third-largest economy. Investors, fearing a possible default, are demanding high interest rates on Italian debt. And these high interest rates, by raising the burden of debt service, make default more likely. ...

To save the euro, this threat must be contained. But ... here’s the problem: All the various proposals ... ultimately require backing from major European governments, whose promises to investors must be credible for the plan to work. Yet Italy is one of those major governments; it can’t achieve a rescue by lending money to itself. And France, the euro area’s second-biggest economy, has been looking shaky lately... There’s a hole in the bucket, dear Liza, dear Liza. ...

What makes the story really painful is the fact that none of this had to happen. ... Britain, Japan and the United States ... have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies. If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically. ...

But such action, we keep being told, is off the table. The statutes ... supposedly prohibit this kind of thing, although one suspects that clever lawyers could find a way to make it happen. The broader problem, however, is that the whole euro system was designed to fight the last economic war. It’s a Maginot Line built to prevent a replay of the 1970s, which is worse than useless when the real danger is a replay of the 1930s. ...

The ... European elite, in its arrogance, locked the Continent into a monetary system that recreated the rigidities of the gold standard, and — like the gold standard in the 1930s — has turned into a deadly trap.

Now maybe European leaders will come up with a truly credible rescue plan. I hope so, but I don’t expect it.

The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.

The automation of more and more work once done by humans is the central theme of “Race Against the Machine,” an e-book to be published on Monday. “Many workers, in short, are losing the race against the machine,” the authors write.

Erik Brynjolfsson, an economist and director of the M.I.T. Center for Digital Business, and Andrew P. McAfee, associate director and principal research scientist at the center, are two of the nation’s leading experts on technology and productivity. The tone of alarm in their book is a departure for the pair, whose previous research has focused mainly on the benefits of advancing technology. ...

Faster, cheaper computers and increasingly clever software, the authors say, are giving machines capabilities that were once thought to be distinctively human, like understanding speech, translating from one language to another and recognizing patterns. ...

The skills of machines, the authors write, will only improve. ... Yet computers, the authors say, tend to be narrow and literal-minded, good at assigned tasks but at a loss when a solution requires intuition and creativity — human traits. A partnership, they assert, is the path to job creation in the future.

“In medicine, law, finance, retailing, manufacturing and even scientific discovery,” they write, “the key to winning the race is not to compete against machines but to compete with machines.”

Sunday, October 23, 2011

I didn't know that prior to the crisis, i.e. in the period from 1989 to 2006, "Approximately half of all taxpayers with children used the Earned Income Tax Credit (EITC) at least once during this 18-year period." And the people who use the program pay far more in taxes than the EITC uses:

Taken together with other research, the new study suggests that while the EITC helps some workers who are persistently paid low wages, for most families who use it, the credit provides effective but temporary help during hard times. ...

The study, from Tim Dowd of the Joint Committee on Taxation and John Horowitz of Ball State University, examined EITC use from 1989 to 2006 and found:

Approximately half of all taxpayers with children used the EITC at least once during this 18-year period.

A large majority (61 percent) of those using the EITC did so for only one or two years at a time — only 20 percent used it for more than five straight years (see graph).

The EITC goes to working people — the overwhelming majority of them families with children — with incomes up to roughly $49,000. Earlier unpublished research from Dowd and Horowitz found that EITC users pay much more in federal income taxes over time than they receive in EITC benefits. Taxpayers who claimed the EITC at least once during the 18-year period from 1989 through 2006 paid several hundred billion dollars in net federal income tax over this period, after subtracting the EITC and any other refunds.

Dowd and Horowitz’s new study also found that EITC use is highest when children are youngest — which is also when parents’ wages are lowest. (Working parents’ wages rise, on average, as their children grow up.) This finding is particularly important given the importance of income for young children’s learning and the evidence that poverty in early childhood may reduce children’s earnings as adults.

we must tell the truth about the EITC... They are not tax credits; they are welfare payments – and must be eliminated

What is their solution?:

Oh, but you might ask, what would you do for low-income families? Well, we can’t offer more tax cuts to those who don’t pay taxes... But we could make this promise: by fostering a true free market society – one that is devoid of over-taxation, regulation, litigation, and yes – subsidization – they would have a realistic opportunity to receive a decent paycheck, instead of a handout.

And what if free markets don't do the job? Republicans who want to scale back the EITC should heed the words of their hero:

President Ronald Reagan ... called it "the best anti-poverty, the best pro-family, the best job-creation measure to come out of Congress."

When you believe, falsely, that 47% of the people are essentially leeches living off the other 53% (instead of viewing them as the people who do much of the hard work in society to create the wealth the upper tiers enjoy but get little in return -- wages have lagged behind productivity), this kind of warped view is the outcome. If the "Approximately half of all taxpayers with children used the EITC" in the last 18 years were to stop working -- if they actually became the deadbeats the right portrays them to be -- the severe economic problems that we'd have would give us a much better sense of their value.

Eschaton: Why Don't They Lend Me $30 Billion On The Security Of My Cats?: If we're going to actually move to more "unconventional" monetary policy, can we please recognize that the reason to do so is largely because conventional monetary policy - acting through the banking system - isn't working? We should understand that it isn't working because it almost destroyed the world a few years ago and is about to do so again because, you know, nothing changed and the overpaid assholes who almost destroyed the world then are still in charge. If we're going to give out dodgy loans, how about giving dodgy loans to people who might do something with the money other than visiting the Great Casino?

Point taken.

Touché.

I will report to the reeducation camp tomorrow...

I have been saying that coordinated fiscal and monetary policy--jen-U-ine helicopter drops or simple government-print-and-buy-useful-stuff--is the superior way to accomplish nominal GDP targeting, and that doing so via monetary policy alone runs risks.

be confident that the policy will not be reversed when the economy emerges from its liquidity trap,

be confident that the policy will succeed and that they should start spending now in anticipation of the faster nominal GDP growth that the policy will produce, plus

a little bit of taking risk onto the Federal Reserve's balance sheet and so freeing up private financier risk-bearing capacity to expand their loan portfolio.

Mostly, that is, the policy is a policy that succeeds if it is generally expected to succeed and fails if it is generally expected to fail. It thus has the confidence fairy nature.

To the extent that the policy does not have the confidence fairy nature, it is because it changes asset supplies here and now and thus private financiers' incentives to lend and businesses' incentives to produce. It does so because the policy involves swapping one asset for another asset that is not the same.

Right now because we are in a liquidity trap short-term Treasury bills and cash are effectively, for the moment, the same asset: they are both short-term zero-yield safe nominal government liabilities. Very few believe that the Federal Reserve's buying Treasury bills for cash and saying: "See! We are doing something! Nominal GDP growth will be faster! You should raise your expectations of real growth and inflation and act accordingly!" would actually do anything. By contrast, if the Federal Reserve buys long-term Treasury or agency or private debt the assets it is buying carry an expectational term premium, duration risk, and (perhaps) default risk: they are not identical to the assets that they are selling. Because the private sector's asset holdings change, private-sector financiers and businesses have incentives to change their behavior even if they don't buy the appearance of the confidence fairy at all--and the fact that they will change their behavior even if they don't believe is a reason for people to believe.

The superiority of unconventional monetary policy thus works off of the fact that the assets the government is buying are different than the assets it is selling--and thus the more different the assets it buys from the assets it sells, the greater the non-confidence-fairy bang from the policy.

What asset is most different from cash?

With a helicopter drop, the Federal Reserve sells cash and it buys… nothing at all. Cash and nothing are pretty different assets. Add cash to private-sector portfolios and take nothing away, and portfolios have shifted in meaningful ways and people will change what they do.

With print-money-and-buy-useful-things, the government sells cash and buys… roads, bridges, research into public health, flu shots, killer robots--all kinds of things that are very very different indeed from cash.

Thus--as Milton Friedman's teacher Jacob Viner knew well back in 1933--coordinated fiscal and monetary expansion via printing money and buying useful stuff (or handing it out via helicopter drops) is a policy that really does not have the confidence fairy nature. Because it does not require confidence to start working, it will (probably) work much more rapidly and certainly.

Saturday, October 22, 2011

When this column appeared appeared on MSN.com, it got hundreds of comments (it was originally published here). I didn't read them, the 73% thumbs down (plus the email I received) was enough to tell me what the comments probably said, and a few people who did read them said I shouldn't bother -- for the most part they hated it.

Here's the unedited version:

Raise Taxes on the Wealthy: It’s the Fair Thing to Do: Many economists worry that making societies more equal through income redistribution lowers economic growth. This “big tradeoff” between equality and efficiency, which is supported by comparisons of capitalist and socialist countries, implies that there is a limit to how much redistribution a society should pursue. At some point the tradeoff of more equality for less output – which worsens as we push toward more and more equality – becomes intolerable.

The Bush tax cuts were justified, in part, by the claim that equity had overshadowed efficiency in tax policy decisions. Taxes on the wealthy and the inefficiencies that come with them were much too high, it was argued, and lowering taxes would cause output to go up enough to lift all boats substantially. Accordingly, the lower end of the income distribution would fare much better after income trickled down than it would under redistributive policy.

The economy did grow after the tax cuts, but the rate of growth was unremarkable, especially for jobs, and there’s little evidence that the Bush tax cuts caused large increases in output growth as promised. In fact, there’s little evidence that they had any effect at all.

And the tax cuts at the upper end of the income distribution did nothing to correct for the fact that although worker productivity was rising, wages remained flat – a problem that began in the mid 1970s. This was an indication that something was amiss in the mechanism that distributes income to different members of society. Workers were helping to increase the size of the pie, but income did not trickle down as promised and their share of the pie was no larger than before.

This is not the only way in which the distribution of income has become disconnected from productivity. While some argue that those at the top of the income distribution earn every cent they receive, and hence deserve to keep all of it, there is plenty of evidence that the income of financial executives, CEOs of major corporations, etc. exceeds the value of what they contribute to society by a considerable margin. That holds true even without the financial crisis, but how, exactly, can we justify the extraordinarily high income of this group when the result of their actions was to ruin the economy?

If those at the top of the income distribution receive far more than the value of what they create, and those at lower income levels receive less, then one way to correct this, at least in part, is to increase taxes at the upper end of the income distribution and use the proceeds to protect important social programs that benefit working class households, programs that are currently threatened by budget deficits. This would help to correct the mal-distribution of income that is preventing workers from realizing their share of the gains from economic growth.

And there is another reason why taxes on the wealthy should go up. Someone has to pay taxes, and the question is how to distribute the burden among taxpayers. Many believe, and I am one of them, that progressive taxes are the most equitable way to do this. In particular, the last dollar of taxes paid should cause the same amount of sacrifice for rich and poor alike.

We face a choice between cutting key benefits for the middle class and creating an ever more unequal society, or raising taxes on the wealthy to preserve the social programs that lower income households rely upon. We hear that raising taxes is unfair, and that tax increases will harm economic growth. But there’s nothing unfair about correcting the mal-distribution of income that we’ve seen in recent decades, or about making sure the burden from paying taxes is more equitable than it is now. And there’s no reason to fear that economic growth will be lower if taxes are increased. Cutting taxes on the wealthy during the Bush years didn’t stimulate growth and raising taxes back to the levels we’ve had in the past – times when growth was quite robust – won’t have much of an effect either.

The claim that there is a tradeoff between equity and efficiency was a key part of the argument for tax cuts for the wealthy, but the tradeoff didn’t materialize. We sacrificed equity for the false promise of efficiency and growth, and society is now more unequal than at any time since the early part of the last century. It’s time to reverse that mistake.

The flat tax is a fraud. It raises taxes on the poor and lowers them on the rich. ... The rich usually pay a higher percent of their incomes in income taxes than do the poor. A flat tax would eliminate that slight progressivity.

Nowadays most low-income households pay no federal income tax at all – a fact that sends many regressives into spasms of indignation. They conveniently ignore the fact that poor households pay a much larger share of their incomes in payroll taxes, sales taxes, and property taxes (directly, if they own their homes; indirectly, if they rent) than do people with high incomes. ...

The truth is the current tax code treats everyone the same. It’s organized around tax brackets. Everyone whose income reaches the same bracket is treated the same as everyone else whose income reaches that bracket (apart from various deductions, exemptions, and credits, of course).

For example, no one pays any income taxes on the first $20,000 or so of their income... People in higher brackets pay a higher rate only on the portion of their income that hits that bracket — not on their entire incomes.

So when Barack Obama calls for ending the Bush tax cut on incomes over $250,000, he’s only talking about the portion peoples’ incomes that exceed $250,000. He’s not proposing to tax their entire incomes at the higher rate that prevailed under Bill Clinton.

Republicans have tried to sow confusion about this. They want Americans to believe, for example, that if the Bush tax cut ended, small business owners with incomes of $251,000 a year would suddenly have to pay 39 percent of their entire incomes in taxes rather than 35 percent. Wrong. They’d only have to pay the 39 percent rate on $1,000 – the portion of their incomes over $250,000. ...

The Republicans’ push for a flat tax masks what’s really going on.

Remember: The top 1 percent is now raking in over 20 percent of the nation’s total income and owns over 35 percent of the nation’s wealth. Under almost anyone’s view of fairness, these are grotesque portions. They’re especially large relative to what they were as recently as thirty years ago, when the top 1 percent raked in under 10 percent. And these huge portions at the top continue to increase.

Simple fairness requires three things: More tax brackets at the top, higher rates in each bracket, and the treatment of all sources of income (capital gains included) exactly the same. ...

The confusion over marginal tax rates (i.e. that higher tax rates only apply to income past certain thresholds) is widespread and an obstacle to progressive tax reform.

Many of the protestors in New York City and around the country are jobless college graduates. The majority in all likelihood financed their education through federally subsidized student loans. A central characteristic of today’s generation of student loans is that, unlike most debts, they cannot automatically be discharged in bankruptcy. As a consequence, they are one of the few expenses in our society for which an individual is likely to be accountable throughout his life. As a nation, we teach our most promising youth, from the age of 18 on, the importance of accountability. We use the federal government to subsidize an investment in human capital. In return, the beneficiaries enter into a lifetime of responsibility and accountability. It is a sacred contract. It is arguably one of the best, and potentially harshest, lessons of accountability associated with capitalism in our society today.

Now, let’s contrast this high accountability with the behavior that occurred in our financial sector. When our largest financial firms created havoc in the U.S. economy through undisputed greed, mismanagement, and extreme risk, some important things happened. First, the government bailed the companies out without demanding any substantial change in behavior, and then the individuals responsible were not held accountable through civil or criminal law. As a result, the people who brought the nation close to the brink of economic collapse and caused untold pain and suffering — which continues to this day — returned after a brief hiatus to record levels of compensation. Individuals who earned tens of millions of dollars continue to earn these extraordinary sums. They have never been called to account for their deeds. ...

Now let’s contrast the kids on the street with the employees of The Street. The kids are accountable for their debts. They know it, and they simply want jobs so they can fulfill their civic responsibilities. In contrast, the occupants of the building on Wall Street act as if the rules of accountability — which are central to a viable system of capitalism — apply to everyone except them. Instead, many of the Wall Street elite have developed a dangerous sense of entitlement. ...

Friday, October 21, 2011

...The economy looks to be growing in a range of 2-3 percent. This is roughly fast enough to keep even with the growth of the labor force. That implies that we are making zero progress in putting people back to work.

Unfortunately, because many economists misread the economy and raised the specter of a double-dip, this slow growth is likely to be seen as good. It isn't and the double-dippers have done the country a serious disservice by creating a set of incredibly low expectations against which economic performance is now being measured.

As I have previously stated, the economy was clearly not in recession in the third quarter, and therefore near-term data would certainly not be consistent with a recession. Indeed, this has been the case. If you expected the bottom to fall out of the economy in the fall, you have been disappointed.

Moreover, the primary reason to believe in a reasonably high probability of recession had little to do with the US data to begin with. To be sure, the overall low rates of growth in this "recovery" does imply that downward negative shocks will push us more easily into recession, and this suggests we may face an increase in recession scares in the years ahead. That said, the first half slowdown is really only a supporting character in the recession story. The lead character was and remains the European situation.

And despite the seemingly endless optimism on Wall Street that Europe will come to an agreement that forestalls a deeper crisis, the reality appears to be very different. My interpretation is the press reports suggest complete and total disarray among European government, as 17 economies all with different objective functions struggle to define the meaning of "Union." This is not stuff for the feint of heart. The differing objective functions and the subsequent need to make all parties happy by itself suggests that at best only a partial solution is at hand, and we are way beyond partial solutions. Moreover, beyond governmental agreement comes the issues of force feeding capital to the banks and the willingness of Greece's bondholders to accept a significantly higher haircut without creating a credit event. I kind of hate to be a pessimist, but good luck putting all that in place by next Wednesday.

Meanwhile, as Edward Harrison points out, while Wall Street may be buying what the EU is selling, European financiers see the writing on the wall. Italian yields are nearing 6%, effectively unwinding the efforts of the ECB to contain the crisis with their earlier bond-buying campaign. Moreover, yield spreads throughout Europe are blowing out. Calculated Risk was always found of saying "we are all subprime now." Well, increasingly it looks like all of the Eurozone is the periphery.

Finally, over at The Street Light, Kash reports Greece is most likely on their last austerity package:

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

Does this get better before it gets worse? History says no. Back to Edward Harrison:

It seems to me that we risk a true Armageddon scenario here from dithering.

A major credit event in Europe looks inevitable. Would a European meltdown endanger the US recovery? We are looking at two channels, trade and financial. I tend to discount the trade channel. As a general rule, I think the propagation of such shocks is too weak to alter the fundamental cyclical forces underlying the US economy. The potential for financial shocks, however, keeps me up at night - this is the key to the US recession story. There is a nontrivial chance that credit event in Europe triggers a credit event in the US. This following quote from Bloomberg only increases my unease:

“We have looked very carefully at bank exposures both to foreign sovereigns and to foreign banks,” Bernanke said. “The exposures of U.S. banks to the most troubled sovereigns --Portugal, Ireland and Greece -- is quite minimal. So the direct exposures there are not large.”

That sounds just a little too much like there is no housing bubble and the subprime crisis is "contained." When it comes to how financial events resonate throughout the US economy, it seems best to bet against Federal Reserve Chairman Ben Bernanke.

Because of the uncertainties surrounding the European crisis and whether or not it induces a regime change in the US economy, forecasters lack conviction about the recession calls, with most circling around 50-50. At the same time, however, I don't see that the competing forecast could in anyway be called optimistic. Optimistic relative to recession, but the baseline forecast remains that of an economy still struggling along in the 2-3% range - a range no one thinks is acceptable given the current high levels of unemployment.

Finally, the forecasts of a double-dip did not do a disservice by changing expectations, as Baker suggests. In fact, I think clearly the opposite occurred. The concerns about the double-dip prodded the Federal Reserve to step up their stimulus efforts, with possibly more on the way. Ultimately, the Federal Reserve was pushed to go where it should have been in the first place.

P.S. I think that we are sufficiently past the last recession that the next recession stands on its own. The term "double-dip" is not really accurate.

As I said the other day, the GOP's jobs proposals amount to picking something that they (or the people who finance their campaigns) don't like — the EPA, Dodd-Frank, health care legislation, Sarbanes-Oxley, etc. — and then finding some way to argue that eliminating it will create jobs:

So what is the G.O.P. jobs plan? The answer, in large part, is to allow more pollution. ... Both Rick Perry and Mitt Romney have ... put weakened environmental protection at the core of their economic proposals, as have Senate Republicans. Mr. Perry has put out a specific number — 1.2 million jobs — that appears to be based on a study released by the American Petroleum Institute ... claiming favorable employment effects from removing restrictions on oil and gas extraction. The same study lies behind the claims of Senate Republicans.

But does this oil-industry-backed study actually make a serious case for weaker environmental protection as a job-creation strategy? No.

Part of the problem is that the study relies heavily on an assumed “multiplier” effect, in which every new job in energy leads indirectly to the creation of 2.5 jobs elsewhere. Republicans, you may recall, were scornful of claims that government aid that helps avoid layoffs of schoolteachers also indirectly helps save jobs in the private sector. But I guess the laws of economics change when it’s an oil company rather than a school district doing the hiring.

Moreover,... the big numbers in the report are projections for late this decade. The report predicts fewer than 200,000 jobs next year, and fewer than 700,000 even by 2015. You might want to compare these numbers with ... the 14 million Americans currently unemployed, and the one million to two million jobs that independent estimates suggest the Obama plan would create, not in the distant future, but in 2012. ...

More pollution, then, isn’t the route to full employment. But is there a longer-term economic case for less environmental protection? No. ... The important thing to understand is that ... pollution ... does real, measurable damage, especially to human health. ...

How big are these damages? A new study by researchers at Yale and Middlebury College ... estimates ... that there are a number of industries inflicting environmental damage that’s worth more than the sum of the wages they pay and the profits they earn — which means, in effect, that they destroy value rather than creating it. ...

Republicans, of course, have strong incentives to claim otherwise: the big value-destroying industries are concentrated in the energy and natural resources sector, which overwhelmingly donates to the G.O.P. But the reality is that more pollution wouldn’t solve our jobs problem. All it would do is make us poorer and sicker.

Simon Johnson ... said that a current member of the Fed told him he was “disappointed there hadn’t been a ticker-tape parade” for policymakers who, in the central banker’s mind, had saved the economy.

Suppose the fire department fails to do adequate inspections, and a big fire breaks out because of it. If that same fire department puts it out and saves the day, do we cheer them for cleaning up their own mess? I think not.

Thursday, October 20, 2011

[Gave a talk this morning, see here, and traveling this afternoon, so just a quick drive by post from the airport for now.]

Alan Blinder:

How to Clean Up the Housing Mess, by Alan Blinder, Commentary, WSJ: About four years ago, as the housing bust worsened, our country faced an entirely predictable problem: A huge wave of foreclosures was headed our way. The issue of the day was how to stop it before it engulfed the entire economy. My suggestion then was to revive the Depression-era Home Owners' Loan Corporation, which refinanced about a tenth of all the mortgages in America and closed its books with a small profit. Never mind the details; the suggestion was ignored. Maybe there were better ideas, anyway.

Sadly, however, we did almost nothing to stop the predicted foreclosure wave, which is now drowning us. The issue at this late date is how we can mitigate the damage.

One oft-repeated answer comes from the intellectual descendants of Andrew Mellon and Herbert Spencer: liquidate, liquidate, liquidate. Let the housing market find its natural bottom, and the chips fall where they may.

I beg to differ. Some of the reasons are humanitarian. Millions of foreclosures are ruining millions of lives and devastating many communities. We can do better than Social Darwinism.

But many of the reasons are strictly economic. The seemingly-endless housing slump is dragging down our economy. By now, massive underbuilding during the slump far exceeds the overbuilding during the boom. So, by rights, a shortage of houses should be pushing up house prices, incentivizing home builders, and boosting growth in gross domestic product. Instead, actual and prospective foreclosures hang over the housing market like a wet blanket.

These are important and powerful figures. ... There were fewer jobs and they paid less last year, except at the very top where, the number of people making more than $1 million increased by 20 percent over 2009.

The median paycheck -- half made more, half less -- fell again in 2010, down 1.2 percent to $26,364. That works out to $507 a week, the lowest level, after adjusting for inflation, since 1999.

The number of Americans with any work fell again last year, down by more than a half million from 2009 to less than 150.4 million.

More significantly,... close to 10 million workers who did not find even an hour of paid work in 2010. ...

What these figures tell us is that there was a reason voters responded in the fall of 2010 to the Republican promise that if given control of Congress they would focus on one thing: jobs.

But while Republicans were swept into the majority in the House of Representatives, that promise has been ignored. ... Instead of jobs, the focus on Capitol Hill is on tax cuts for corporations with untaxed profits held offshore, on continuing the temporary Bush administration tax cuts -- especially for those making $1 million or more - and on cutting federal spending, which mean destroying more jobs in the short run. ...

The data show why protests like Occupy Wall Street have so quickly gained momentum around the country... Will official Washington look at the numbers and change course? Or do voters need to change their elected representatives if they want to put America back on a path to widespread prosperity?

Real hourly wages fell 0.1% in September from August. After rising briefly at the start of this recovery, real hourly pay is back to about where it was two years ago — despite the fact that worker productivity has risen more than 5% since then.

Safety First, Fracking Second, The Editors, Scientific American: A decade ago layers of shale lying deep underground supplied only 1 percent of America’s natural gas. Today they provide 30 percent. Drillers are rushing to hydraulically fracture, or “frack,” shales in a growing list of U.S. states. ... The benefits come with risks, however, that state and federal governments have yet to grapple with.

Public fears are growing about contamination of drinking-water supplies from the chemicals used in fracking and from the methane gas itself. Field tests show that those worries are not unfounded. ... Yet states have let companies proceed without adequate regulations. They must begin to provide more effective oversight, and the federal government should step in, too.

Nowhere is the rush to frack, or the uproar, greater than in New York. ... Fracking is already widespread in Wyoming, Colorado, Texas and Pennsylvania.

All these states are flying blind. A long list of technical questions remains unanswered about the ways the practice could contaminate drinking water, the extent to which it already has, and what the industry could do to reduce the risks. ...

Scientific advisory panels at the Department of Energy and the EPA have enumerated ways the industry could improve and have called for modest steps, such as establishing maximum contaminant levels allowed in water for all the chemicals used in fracking. Unfortunately, these recommendations do not address the biggest loophole of all. In 2005 Congress—at the behest of then Vice President Dick Cheney​, a former CEO of gas driller Halliburton—exempted fracking from regulation under the Safe Drinking Water Act. Congress needs to close this so-called Halliburton loophole, as a bill co-sponsored by New York State Representative Maurice Hinchey would do. ...